A History of Controlled Foreign Corporations and the Foreign Tax Credit by Melissa Redmiles and Jason Wenrich Figure A s U.S. corporations have expanded their busi- nesses overseas in the last several decades, the Corporate Foreign Tax Credit, in Constant 2004 United States Tax Code has been modified to Dollars, Selected Tax Years 1925-2002 [1] A [Money amounts are in millions of dollars] account for increasingly complex international cor- porate structures and transactions. Two important U.S. income tax Foreign tax Tax year Percentage international tax concepts that have emerged over before credits credit the years are the corporate foreign tax credit and (1) (2) (3) controlled foreign corporations. The corporate for- 1925..................... 12,629 216 1.7 eign tax credit was created to alleviate the burden of 1930..................... 8,054 328 4.1 1940..................... 28,929 783 2.7 double taxation. The income of controlled foreign 1950..................... 123,757 3,637 2.9 corporations has become increasingly subject to U.S. 1960..................... 139,544 7,811 5.6 tax after initially presenting a potential tax deferral 1970..................... 160,414 22,147 13.8 advantage over foreign branches. A brief history of 1980..................... 238,030 57,037 24.0 the foreign tax credit and controlled foreign corpora- 1990..................... 172,617 36,115 20.9 292,106 53,210 18.2 1 2000..................... tions is presented below. 2004..................... 299,555 56,872 19.0 [1] For comparability, money amounts have been adjusted for inflation to 2004 constant Corporate Foreign Tax Credit dollars. The United States generally taxes U.S. companies on their worldwide incomes. Since other countries payroll taxes, can be deducted from foreign-source may also impose a tax on income earned within their income but not credited. Income taxes paid to a lo- borders, U. S. companies with foreign-source income cal authority, such as a province, are eligible for the face potential double taxation. When the income credit. Taxes paid for a specific right or service, like tax was first created, Congress addressed this issue a royalty payment for the right to mine, generally by allowing taxpayers to deduct their foreign taxes cannot be credited. After the Technical Amendments when computing taxable income. In 1918, after the Act of 1958, taxpayers could carry their unused for- cost of World War I pushed up both domestic and eign taxes forward for 5 years or back for 2. Figure many foreign tax rates, Congress passed the foreign A shows foreign tax credit amounts for select years tax credit provisions to provide greater relief in cases between 1925 and 2004, in constant 2004 dollars. of double taxation. These provisions permit taxpay- U.S. companies generally are not taxed on the ers the option of either deducting their foreign taxes earnings of their foreign subsidiaries until those earn- when computing their taxable incomes or taking a ings are distributed to the parent company, and thus dollar for dollar credit for them against their U.S. tax cannot claim a direct credit for the foreign taxes paid liabilities. Corporations report the foreign income by the subsidiary. The foreign tax credit provisions, and taxes related to the credit on Form 1118, Compu- however, allow taxpayers an indirect credit for the tation of Foreign Tax Credit—Corporations. foreign “taxes deemed paid.” Taxes deemed paid are computed as a share of the foreign taxes on the Creditable Taxes earnings out of which the distribution was made pro- To be eligible for the credit, the tax paid had to be a portionate to the ratio of the distribution to the total foreign income tax. Although the precise definition earnings. To be eligible for the indirect credit, the of a foreign income tax has changed somewhat over U.S. company must own a certain percentage of the the years, the basic idea remains today. Other taxes, foreign subsidiary’s voting stock. In 1962, the own- such as value-added taxes, excise, property, and ership percentage was lowered from the original 50 percent to 10 percent. Until 1976, taxpayers could Melissa Redmiles and Jason Wenrich are economists with the claim the credit down to the second tier of owner- Special Studies Returns Analysis Section. This article was ship, as long as the second tier corporation was at prepared under the direction of Chris Carson, Chief. least 50-percent owned by the first tier corporation. 1 For a more detailed description of international taxation, see Doernberg, Richard L. (1999), International Taxation, West Group, St. Paul, MN. 129 A History of Controlled Foreign Corporations and the Foreign Tax Credit The Tax Reform Act of 1976 expanded the level of investments abroad to generate additional, low-taxed ownership to three tiers and changed the percentage foreign income that could be combined with higher requirements to 10 percent for all tiers, provided that tax income.2 the combined percentage ownership of all tiers is at Congress placed further restrictions on the for- least 5 percent. Congress gradually expanded the lev- eign tax credit in the Tax Reduction Act of 1975 and el of ownership down to six tiers, but the 5-percent the Tax Reform Act of 1976. These laws eliminated rule remains in effect. the per country limitation option and added a new limitation category, dividends from a Domestic In- Limitations and Reductions ternational Sales Corporation (DISC).3 Income that As originally enacted, the foreign tax credit had a did not fit into the interest category or DISC dividend major drawback. Since companies could credit an category fell into an overall or general limitation cat- unlimited amount of tax paid to countries with tax egory. This legislation also introduced a reduction in rates that exceeded the U.S. rate, they could off- credit for taxes paid on foreign oil and gas extraction set some of their tax on domestic income with the income equivalent to the amount of foreign taxes credit for taxes on foreign income. To remedy this, paid, accrued, or deemed paid on foreign oil and gas Congress added a limitation to the foreign tax credit extraction income that exceeded a certain percentage in the Revenue Act of 1921. The limitation essen- of foreign oil and gas extraction taxable income. The tially caps foreign taxes credited to the U.S. rate, percentage has changed over time and is currently by limiting the amount of credit to a corporation’s set at the highest rate of corporate tax, 35 percent for U.S. income tax liability multiplied by the ratio of Tax Year 2006. In addition, the 1976 Act included foreign-source income to worldwide income. When boycott legislation. Now, taxpayers who agree to first enacted, taxpayers computed the limitation us- participate in an unsanctioned boycott may need to ing total foreign-source taxable income. A limitation reduce their foreign credits or their foreign taxes eli- computed using this method later become known as gible for credit. an overall limitation. Finally, these laws added an overall foreign loss One problem with the limitation was that taxpay- recapture. The intent of the overall loss recapture ers could still offset some domestic tax liability by was to limit the amount of domestic tax liability that combining amounts of income earned in high-tax could be offset by foreign losses. Before this legisla- countries with income in low-tax countries, in their tion, if a taxpayer had an overall foreign loss in one computation of the credit limitation. What, if any- year and an overall foreign gain in a subsequent year, thing, should be done about this issue has been the the taxpayer could use all of his or her foreign-source driving force behind much subsequent foreign tax taxable income in the year with the gain in comput- credit legislation. Beginning in 1932, Congress re- ing the foreign tax credit limit. Since 1976, in the quired taxpayers to compute the limitation on a per years when taxpayers have an overall foreign gain, country basis. In addition, the sum of all allowable they must treat the smaller of all overall losses from credits from all countries could not exceed the overall previous years or 50 percent of their current foreign- limitation. The latter requirement was removed from source income as domestic source income. the Internal Revenue Code in 1954. Public Law 86- In 1985, the Treasury Department recommended 780, enacted in 1960, granted taxpayers the ability reinstating the per country limitation. U.S. compa- to elect either an overall limitation or a per country nies with substantial foreign-source income objected, limitation. In 1962, Congress introduced a separate and Congress compromised by greatly expanding the limitation for nonbusiness-related interest. This categories of income requiring a separate limitation prevented taxpayers from making interest-bearing in the Tax Reform Act of 1986.4 Beginning with Tax 2 Andersen, Richard E. (1996), Foreign Tax Credits, Warren, Gorham & Lamont, Boston, MA. 3 Dividends from a DISC or former DISC refer to dividends from a Domestic International Sales Corporation (DISC) that are treated as foreign-source income. A DISC is a small domestic corporations whose activities are primarily exported-related. A portion of the DISC’s income was not subject to tax until it was distributed to shareholders. Tax advantages of DISCs were repealed in 1984. 130 4 Gustafson, Charles H.; Robert J. Peroni; and Richard Crawford Pugh (2001), Taxation of International Transactions, Materials, Text and Problems, West Group, St. Paul, MN. A History of Controlled Foreign Corporations and the Foreign Tax Credit Year 1987, the limitation categories included: general ing stock together own 50 percent or more of either limitation income, passive income, high withholding the voting stock or the value of the stock.